by Depreciation refers to the allocation of the cost of a fixed asset over its useful life. It is an essential concept in accounting and helps businesses allocate the expense of using an asset over time. Two commonly used methods of depreciation are the Straight Line Method (SLM) and the Written Down Value (WDV) Method, each of which treats the depreciation of an asset in a different way.
1. Straight Line Method (SLM):
Straight Line Method (SLM) of depreciation is the simplest and most widely used method. Under this method, the depreciation expense is the same every year, meaning the asset loses an equal amount of value over its useful life. The total depreciation is spread evenly over the asset’s expected life, regardless of its usage or productivity.
Formula for Depreciation:
Depreciation = Cost of Asset − Salvage Value / Useful Life of Asset
Where:
- Cost of Asset is the initial purchase price of the asset.
- Salvage Value is the residual value at the end of the asset’s useful life.
- Useful Life is the number of years the asset is expected to be used.
Example:
Consider a machine purchased for ₹100,000 with a salvage value of ₹10,000 and a useful life of 5 years. The annual depreciation under the SLM would be:
Depreciation = 100,000 − 10,0005 = ₹18,000 per year
This means that ₹18,000 will be charged as depreciation every year for five years.
Advantages of SLM:
- Simplicity: The method is easy to calculate and understand, requiring minimal record-keeping.
- Predictability: The same amount of depreciation is charged each year, making it easier to budget and plan for expenses.
- Consistency: It provides a consistent depreciation expense over the asset’s useful life, which is ideal for assets that are used consistently.
Disadvantages of SLM:
- Does not reflect actual usage: This method assumes the asset loses value evenly, which may not reflect its actual usage or productivity.
- Overstates value in the earlier years: In cases where the asset loses more value in the early years of use, SLM may not accurately represent the real wear and tear.
2. Written Down Value Method (WDV):
Written Down Value (WDV) Method, also known as the Declining Balance Method, calculates depreciation based on the book value of the asset at the beginning of the year. Under this method, the depreciation charge is higher in the initial years of the asset’s life and decreases over time as the asset’s value decreases. This method is more suitable for assets that lose value more quickly in the earlier years of usage.
Formula for Depreciation:
Depreciation = Depreciation Rate × Book Value at the Beginning of the Year
Where:
- Depreciation Rate is typically calculated as a percentage of the cost of the asset or using a fixed percentage determined by the company’s policy or tax laws.
- Book Value is the asset’s value at the beginning of the year after deducting any previous depreciation.
Example:
Consider the same machine purchased for ₹100,000, with a depreciation rate of 20% per year. Under the WDV method, the depreciation in the first year would be:
Depreciation for Year 1 = 20% × 100,000 = ₹20,000
At the end of the first year, the book value of the machine becomes:
Book Value at Year 2 = 100,000 − 20,000 = ₹80,000
In the second year, the depreciation would be:
Depreciation for Year 2 = 20% × 80,000 = ₹16,000
This process continues, with the depreciation decreasing each year as the book value decreases.
Advantages of WDV:
- Reflects actual wear and tear: This method accounts for the fact that many assets lose more value in their earlier years of use, making it more suitable for assets that are used intensively in the early years.
- Higher depreciation in early years: It allows businesses to match higher depreciation expenses with the higher maintenance costs in the earlier years of an asset’s life.
- Tax Benefits: In many cases, businesses prefer this method for tax purposes because it allows for higher depreciation deductions in the early years, reducing taxable income.
Disadvantages of WDV:
- Declining Depreciation: The depreciation decreases over time, which means that in the later years, the depreciation expense is much lower, potentially not reflecting the ongoing costs of maintaining the asset.
- Complex Calculation: The method requires recalculating depreciation every year as the book value changes, which can be cumbersome and time-consuming.
- Inconsistent Expense: The depreciation expense varies each year, which may complicate financial planning and forecasting.
Comparison of SLM and WDV:
| Aspect | SLM (Straight Line Method) | WDV (Written Down Value Method) |
|---|---|---|
| Depreciation Calculation | Fixed amount each year | Decreases each year as the asset value decreases |
| Depreciation Expense | Same amount throughout the useful life | Higher in the initial years, decreasing later |
| Suitability | Ideal for assets with uniform usage over time | Suitable for assets with rapid early depreciation |
| Record Keeping | Simpler to maintain | Requires recalculating each year |
| Impact on Profit | More predictable expense allocation | Higher expense in the initial years |
| Effect on Tax | Lower tax deduction in earlier years | Higher tax deduction in earlier years |
| Usefulness | For long-term, stable assets like buildings | For assets like machinery, vehicles, etc. |
